On June 1, 2016, the Securities and Exchange Commission ("SEC") announced a settlement with Blackstreet Capital Management, LLC, a private equity fund adviser ("Blackstreet"), and its owner, Murry N. Gunty, following an investigation finding that, among other federal securities law violations, Blackstreet received transaction-based compensation for providing brokerage services for funds that it managed while not being registered as a broker.[1] This announcement marks the first SEC enforcement action against a private equity fund adviser for failing to register as a broker in violation of Section 15(a) of the Securities Exchange Act of 1934, as amended (the "Exchange Act").

Enforcement Action Background

Section 15(a)(1) of the Exchange Act makes it unlawful for a broker to effect transactions in securities unless registered with the SEC under Section 15(b) of the Exchange Act. Section 3(a)(4) of the Exchange Act generally defines "broker" as any person engaged in the business of effecting transactions in securities for the account of others.

Blackstreet, a registered investment adviser, provided investment advisory and management services to two funds focused on underperforming portfolio companies. In exchange for these services, Blackstreet earned a management fee equal to 2% of the aggregate capital commitment, as well as 20-25% of all distributions in excess of the sums the funds invested. Blackstreet also managed the acquisitions and dispositions of portfolio companies on the funds' behalf, which included soliciting deals, identifying buyers and sellers, negotiating and structuring transactions, arranging financing and executing transactions. Blackstreet received at least $1,877,000 in transaction-based compensation for providing these services. Although the funds' governing documents permitted Blackstreet to charge transaction and brokerage fees, Blackstreet never registered with the SEC as a broker nor affiliated itself with a registered broker. According to the SEC, Blackstreet's failure to register as a broker constituted a willful violation of the registration requirements of the Exchange Act.

In addition, the SEC found that Blackstreet committed a number of violations under the Investment Advisers Act of 1940, as amended (the "Advisers Act"), including, among other things, the following:

Blackstreet charged fees to portfolio companies in one fund for providing operating partner oversight, but the fund's limited partnership agreement ("LPA") did not disclose that Blackstreet received such fees, resulting in a conflict of interest.

Blackstreet used fund assets to make political and charitable contributions and to pay for entertainment expenses, which were neither authorized nor disclosed in the fund's governing documents.

Blackstreet improperly purchased shares in portfolio companies from a departing employee without disclosing its financial interests or obtaining appropriate consent to engage in the transaction.

Blackstreet failed to adopt and implement compliance policies and procedures reasonably designed to prevent violations of the Advisers Act.

Without admitting or denying the SEC's findings, Blackstreet agreed to be censured, and Blackstreet and Mr. Gunty agreed to cease and desist from future violations of the federal securities laws. Blackstreet and Mr. Gunty also agreed to pay more than $3.1 million, which included $500,000 in civil penalties, $2.339 million in disgorgement and $287,737 in prejudgment interest.

Prior SEC Guidance

In a speech before the American Bar Association Trading and Markets Subcommittee in April 2013, David Blass, former Chief Counsel of the SEC Division of Trading and Markets, discussed the issue of whether certain fees received by private equity fund advisers could subject the advisers to regulation as brokers under the Exchange Act.[2] Mr. Blass expressed the view that the practice of a private fund adviser taking transaction fees appeared to cause the adviser to fall within the meaning of the term "broker" as defined in the Exchange Act. He addressed two scenarios where a private equity fund adviser may be required to register as a broker-dealer: (1) where the adviser "pays its personnel transaction-based compensation for selling interests in a fund" or has personnel "whose only or primary functions" are selling fund interests, and (2) where the adviser, its affiliates or its personnel "receive transaction-based compensation for purported investment banking or other broker activities" relating to fund portfolio companies.

In the same speech, Mr. Blass noted that, to the extent fund advisers' management or other advisory fees are wholly reduced or offset by a transaction fee, one could view the transaction fee as simply another way to pay the management or other advisory fee that is otherwise due to the adviser's fund, which, in his view, would not appear to raise broker-dealer registration concerns. The Blackstreet settlement did not indicate whether the transaction-based compensation received by Blackstreet was subject to offset against the management fees paid by the funds, and it is not clear whether the SEC shares Mr. Blass’ view.

Key Takeaways

The Blackstreet enforcement action serves as a reminder to private equity fund advisers of the importance of compliance with broker-dealer registration requirements found in the Exchange Act. As noted in the SEC's Release, Blackstreet was soliciting deals to purchase and sell portfolio companies, identifying buyers and sellers, negotiating and structuring transactions, arranging financing and executing transactions for portfolio companies and was receiving transaction fees for these activities. Each of these activities has been cited by the SEC in previous enforcement actions in support of a finding of broker-dealer status. In the SEC’s press release announcing the Blackstreet enforcement action, Andrew J. Ceresney, Director of the Division of Enforcement, stated that "[t]he rules are clear: before a firm provides brokerage services and receives compensation in return, it must be properly registered within the regulatory framework that protects investors and informs our markets" and that "Blackstreet clearly acted as a broker without fulfilling its registration obligations."[3] While it is not clear whether the enforcement action signals renewed focus by the SEC on the issue of fund advisers acting as broker-dealers without registration, private equity fund advisers should carefully review any investment banking-type services provided to or for portfolio companies, especially those with transaction-based fee structures, to assess the related broker-dealer regulatory implications.

The enforcement action also demonstrates the SEC's focus on the importance of disclosure in a fund's governing documents, particularly with respect to fees and expenses. Fund advisers must make clear what expenses will be charged to the fund, and those expenses must be disclosed in the fund's governing documents. Likewise, fund advisers must strictly follow the fund's governing documents and appropriately resolve conflicts of interest, particularly with respect to transactions between the adviser or its personnel and the fund.

For further information on the Blackstreet enforcement action or to discuss the broker-dealer implications of services provided to or for the benefit of portfolio companies, you may contact Steve Hackman, Eric Goodman, Jon Groff or Paul Huddle.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader’s specific circumstances.